I- INTRODUCTION

II- THE ANALYTICAL FRAMEWORK

III- MACROECONOMIC EQUILIBRIUM

IV- COMPARATIVE STATICS

V- CONCLUDING REMARKS

REFERENCES

ABSTRACT

This paper endogenizes the debt-equity ratio and embodies financial leverage in a cash-in-advance model of endogenous growth. Our analysis finds that the debt-equity ratio is positively related to the balanced-growth rate, since it serves as a ‘financial accelerator’ to stimulate investment projects. Compared to previous studies, this positive relationship gives rise to an additional balancesheet effect, which substantially affects the macroeconomic consequences of monetary and taxation policies. Due to the existence of the balance-sheet effect, we also find that the Friedman rule is not necessarily optimal.

INTRODUCTION

What is the role played by firms’ capital (financial) structures in economic growth? This is an old, but important, question. Modigliani and Miller (1958) propose that the average cost of capital for any firm only reflects the capitalization rate of a pure equity stream of its class and that the capital structure does not matter to the firm’s market value. This implies that capital accumulation is completely independent of firms’ capital structures and financial policies are separated from firms’ investment decisions. Due to the ‘irrelevance of the capital structure’, the early literature on macroeconomics and monetary economics has mostly overlooked the related issue and conducted the growth analysis by simply taking the firms’ capital structure as exogenously given (e.g., Lucas, 1967; Tobin, 1969; Sidrauski, 1967; Lucas, 1980; Kimbrough, 1986;Wang and Yip, 1992; Gomme, 1993; and Mino, 1997).While ‘finance is a veil’ has become widely accepted in the macroeconomics literature, it has not been supported by empirical studies.